Market Efficiency - You Ask the Wrong Question

7/29/2019 Market Efficiency - You Ask the Wrong Question

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Market Efficiency:

You Ask The Wrong Question

Is the market efficient? This central question in finance creates a polarised debate in thetheoretical (academic) and practical (money management) worlds and further afield.

Those who can, do; those who cant, teach1

The tenet of this proverb is certainly breached when we research some of the keycontributors to the debate on market efficiency.

The roots of the Efficient Market Hypothesis (EMH) can be traced back to Paul Samuelsons1965 article: Proof that Properly Anticipated Prices Fluctuate Randomly. A paradox arisesfrom this hypothesis: the more efficient the market, the more random the sequence of pricechanges generated by such a market must be. The most efficient market of all is one inwhich price changes are completely random and unpredictable. In a paper published by J.Doyne Farmer and Andrew Lo2, the authors suggest that this informational efficiency is notan accident but is a direct outcome of many active participants attempting to profit fromtheirinformation.

The paradox was highlighted by Grossman & Stiglitz: If the market were informationallyefficient, then no one would have the incentive to acquire the information on which prices are

based.3

Realistically the EMH, as its name suggests, was never intended to be taken as literally true,merely to serve as a point of departure for our thinking. Despite unrealistic assumptionsand various other flaws (cited even by its principle creators), market efficiency is widelyaccepted by the financial community and used to justify the seemingly relentless trendtowards passive management. According to the September 2011 edition of the CFAmagazine, U$1.3 trillion is invested in exchange traded funds alone.

Market efficiency does not require the market price of a security to be equal to its true valueat every point in time. All it requires is that errors in the market price be unbiased. BenGraham certainly argued for inefficiency when he stated: The market is not a weighingmachine, on which the value of each issue is recorded by an exact and impersonal mechanism

in accordance with its specific qualities. Rather should we say that the market is a voting

machine, whereon countless individuals register choices which are the product partly of

1 George Bernard Shaw, Man and Superman, 19032 J. Doyle Farmer and Andrew Lo, Frontiers of Finance Evolution and Efficient Markets 3 Grossman and Stiglitz, The Impossibility of Informationally Efficient Markets; American Economic Review,1980

www.valueinstitute.org


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reason and partly of emotion.4

However given reasonable assumptions about economic behaviour, it appears logical to thisauthor that markets eventually recognise mispricing and drive prices to fundamental value.But even this is far from the interpretation of the efficient markets fraternity.

Ben Grahams argument against EMH was that ignorance and emotions are powerful factorsin stock pricing, preventing markets from operating anywhere near efficiency. Thus stockvalues, he said, are typically skewed higher or lower than they should be. Individualfundamental investigation of a stocks true worth may show it is temporarily undervalued,hence a bargain waiting to be exploited. This thinking has more recently formed the basisfor the behavioural finance school of thinking.

Opposing Graham on this are David Booth and Rex Sinquefield from the University ofChicago, who set up Dimensional Fund Advisors (DFA) in 1981. This firm embracedinvestment strategies that are strongly influenced by efficient markets academics. Two

Nobel Prize laureates, Robert Merton of Harvard University and Myron Scholes of StanfordUniversity, sit on DFA's board of directors. Another Nobel laureate, Merton Miller ofHarvard, sat on the DFA board until his death in 2000. Two other efficient marketcheerleaders, Eugene Fama of the University of Chicago and Ken French of Dartmouth, arecited by the company as the chief intellectual catalysts.

Sinquefield took part in a famous debate on active versus passive investing with DonaldYachtman in October 1995 in San Francisco. Its my contention that active managementdoesnt make sense theoretically and isnt justified empirically. Other than that, its ok.Passive management, on the other hand, stands on solid theoretical grounds, has enormous

theoretical support, and works very well for investors.

Dimensional Fund Advisors website5 proudly displays the transcript of Sinquefieldsopening statement in favour of passive management. Sinquefield commenced by referringto Adam Smith, who said that a free market is the best way for the social order to allocateresources. He then affirmed that noted Austrian Economist Friedrich Hayek extended thework of Smith, introducing the key idea that the price system is a mechanism forcommunicating information and that the market gathers, comprehends and disseminateswidely dispersed information faster than any system man has deliberately designed.

It seems that Hayeks conclusion is largely untested: Only by far-reaching decentralisation in

a market system with competition and free price fixing is it possible to make full use ofknowledge and information. Which economy fits the description of free price fixing? Forexample, Central Banks certainly stand in the way of interest rates ability to efficiently

facilitate communication between lenders and borrowers.

Value Investor and Austrian economist Chris Leithner offers an interpretation of marketefficiency, which contrasts with that of the Dimensional Fund Advisors director.

4 Ben Graham & David Dodd Security Analysis 6th Edition 20095 http://www.dfaus.com



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Perhaps most importantly, to a Grahamite investor and an Austrian School economist, priceand value are distinct things. Over extended periods of time they tend towards one another.

But at any given moment they will likely differ from one another; and from one moment to the

next they may diverge.6

Leithner stresses that disequilibrium, not equilibrium, characterises the actions among

buyers and sellers. Markets do indeed tend towards market-clearing prices: but they neverattain equilibrium because numerous events the constant change of plans, discovery of newinformation and technology, commission of errors and their discovery and rectification

intrude.

In his 1995 address Sinquefield posed a rhetorical question: So who still believes marketsdont work? In an entertaining presentation his answer grouped active managers withsocialists. Apparently it is only the North Koreans, the Cubans and the active managers.Socialists and active managers are cut from the same cloth, what links them is a disbelief or

scepticism about the efficacy of market prices in gathering and conveying information.

Unfortunately the normally eloquent Yachtmans response is proving impossible to find (ifanyone out there has it please send on to us!). We expect that he would have ignored theslightly incendiary nature of the argument and pointed out that Sinquefield is mistaken tohave equated the efficiency of the system with efficient pricing of assets.

Indeed in his recent book, Columbia University Professor, Stephen Penman states, One mustdistinguish efficient pricing in capital markets, about which the theory was originally

concerned, from the efficiency of the economic system in general and it is efficient capital

markets with which the investor is concerned.7

Ironically, in proving that active managers underperform, Sinquefield referenced a studyby Mark Carhart, then a University of Chicago Ph.D. student. Carhart used a 4-factor model(effectively an extension of the 3-factor model of Fama and French adding momentum tobook-to-market, market cap and liquidity factors). Carhart concluded that adjusting forthese factors, active managers underperform by 1.8% per annum between 1961 and 1993.The core of the irony is that the same Mark Carhart left Goldman Sachs in 2008 havingpresided as the main lieutenant over the now infamous Global Alpha Fund, with assetsshrinking (amid seismic losses) from U$12.5 billion to U$2.5 billion during the financialcrisis in mid-2008.

In a recent interview Carhart was asked about his biggest lesson from the financial crises.His response certainly confirms a change in view from his Ph.D. thesis and a seeminglyobvious move away from the efficient markets school. Probably the most important lessonwas the magnitude of commonality in the investment approach we followed across the

broader investment community. Success in quant investing in the future will hinge on

developing unique ideas that are differential (sic) from competitors. The second lesson is that

models and approaches need to be more dynamic. When evaluating long-term historical price

6 Ludwig von Mises, Meet Benjamin Graham: Value Investing from an Austrian Point of View7 Accounting for Value, Columbia Business School Publishing, 2011



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patterns, its hard to appreciate how quickly the models needed to evolve. Having livedthrough 2007 and 2008 and the earlier LTCM crisis and the Internet bubble I better

appreciate the need for dynamic models which will have more variation in risk and signal

composition.8

Dimensional Fund Advisors have been tremendously successful, both in growing assets, and

also in investment performance terms. Their philosophy that markets work and investorsare rewarded for taking risks is derived from the Fama and French Multi-Factor Model9.Financial science over the last fifty years has brought us to a powerful understanding of the

risks that are worth taking and the risks that are not.10

As proponents of market efficiency, DFA assumes risk factors explain why smallercompanies and those companies valued at low price-to-book are shown to outperform. Ifasset pricing is rational, size and price/book must proxy risk.8

In other words these stocks are higher risk and therefore generate higher returns. But

there is absolutely no evidence that these factors might represent risk! Interestingly theoriginal research by Dimensionals chief intellectual catalysts recognises this: If assetpricing is irrational and size and price/book do not proxy for risk, our results might still be

used to evaluate portfolio performance and measure expected returns from alternative

investment strategies.8

In May 2011 Professor Bruce Greenwald expanded on this point from the perspective of avalue investor. Attempts have been made to associate the higher cross-sectional returns ofcheap stocks with higher levels of risk, but these risk factors never turn out to be empiricallymeasurable independent of cheapness. Behavioural research phenomena such as loss-

aversion, overconfidence, and lottery preference the disproportionate desirability of low

probability, very high reward outcomes account for the value of cheapness much moredirectly.11 Therefore it is very difficult to justify DFAs statement that their investmentstrategy is based on a strong scientific basis!

Maybe this gets to the nub of the issue. There is no science here. The finance world needsto get away from the idea that we can invent some theory or empirical model in a scientificfashion. Charlie Munger evoked Freud when he accused economists of physics envy.Economics is too complex a system and the craving for that physics-style precision does

nothing but get you in terrible trouble.12

Andrew Los witty contribution to this debate at a lecture in Harvard is revealing: Inphysics, you have three laws which explain 99% of physical phenomena. In finance, we have99 laws which explain 3% of economic phenomena.

8 http://www.chicagomaroon.com/2010/4/23/uncommon-interview-with-mark-carhart9Fama and French The Cross section of Expected Returns, Journal of finance. 199210 http://www.dfaus.com/philosophy/dimensions.html11Value Investing's Long Run: what the gradual turn away from modern portfolio theory holds for valueinvesting, Bruce Greenwald May 201112October 2003 Charlie Munger lecture to the economics students at the University of California at SantaBarbara



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The Carhart study mentioned earlier (and many others like it) highlight another generallyaccepted method to assess market efficiency. Carhart measures whether the practitionersactually delivered better performance than the market (adjusted for risk). It is often

argued that unless active managers can systematically outperform, then this is proof thatthe market is efficient. The theory is eminently logical, but in this authors view, is flawed inpractice. It might seem rational to group active managers together and compare their

returns against the market but:

This ignores the reality that on average active managers at best will achieve thereturn of the market. Clearly, more than 50% of people cannot be above averagedrivers!

Most of these studies adjust for risk in a multi-factor manner la Fama andFrench. The case for this model is highly tenuous (as they acknowledgethemselves).

It is not appropriate to just lump together all active managers of different styles(e.g. value, growth, small cap, large cap). See The Superinvestors of Graham-and-

Doddsvillespeech by Warren Buffett at Columbia Business School in 1984 for anargument that a value approach outperforms. The business risk in active management is immense. This has resulted in the

average mutual fund manager hugging indices. Few are willing to stand up andbe counted. How can they outperform?

How many managers are properly incentivised to focus on long-termperformance and are committed to remaining in situ to deliver this?

Sir John Templeton summarised this as follows: If you want to have better performance thanthe crowd you must do things differently than the crowd.

Meanwhile Charlie Munger highlighted the modern lack of tolerance for short-termunderperformance: In investment management today, everybody wants not only to win, butto have a yearly outcome path that never diverges very much from a standard path except on

the upside. Well, that is a very artificial, crazy construct.13

Clearly none of this proves the case for active management, or whether or not the market isefficient, but merely makes the case to be careful when interpreting the theoreticalperformance studies.

The biggest irony is that both schools of thought, that of Sinquefield, Fama and French on

one side and Graham, Yachtman and Greenwald on the other, all advocate a similarinvestment strategy. Both schools believe in outperformance, but for different reasons.

Mathematics professor Edward Thorp, most recently at University of California, is famousfor research into card counting as a strategy for winning at Black Jack and the threeformulae that were forerunners to the Black-Scholes Option Pricing Model. For many yearsThorp has successfully put theory into practice through his two hedge fund vehicles.

13A Lesson on Elementary Worldly Wisdom As It Relates To Investment Management & Business, CharlesMunger USC Business School 1994



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Thorps views on market efficiency are most enlightening: Imagine a casino where everyone

is playing blackjack and theyre all losing 2% because theyre using a naive strategy that onaverage loses that much. Then one person figures out how to get an edge by counting cards.

Did the blackjack market suddenly become inefficient at that point or was it inefficient before

anybody figured this out? If the person who figures out how to count cards does nothing, is the

market still efficient?14

Thorp really shows a masters understanding of the issue, possibly combining his academicand practical experience. The talk about the markets being efficient or inefficient is not quitethe right way to look at it. Its a combination of what is going on in the markets and theparticipants in the marketplace. Market efficiency or inefficiency is a joint property of the

market itself, whats going on in it, and what the participants know and are able to do.However that will vary from person to person; for example Warren Buffett has knowledge

about the fundamentals of a lot of companies, among other things. So in that area the markets

are inefficient from his point of view, but there are a hundred million people out there who

dont have that knowledge and they should behave as if the market is efficient because from

their point of view they dont have an edge at all.14

A managers assertion that he can beat the market because it is inefficient isnt a credib lestatement. It just isnt enough. One needs to be able to demonstrate knowledge that

provides a real and sustainable advantage.

The correct question is not: Is the market efficient? Rather, it should be: What is it aboutyou and your firm that gives you the investment edge?

The Value Investment Institute, September 2011

14The Masters Series, Interview with Edward O. Thorp Volume 12, 2011


Market Efficiency - You Ask the Wrong Question

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